Francis Menassa, JAR Capital — How Macroeconomic Tides Are Changing

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Today’s understanding of economics was largely conceived in response to the problems of the 1970’s. These solutions — Thatcherism and Reaganomics — have survived pretty much unchecked for forty years. That laissez-faire approach to the economy has coincided with a creeping and persistent rise in inequality.

Now, however, after COVID and with the US budget deficit topping $4tn and set to rise further, we have likely entered a new and equally radically bold economic period. Like the last one, this is probably best described as a giant experiment. In many ways, President Biden’s levelling up agenda will make the US economy look and feel a little more European. There is nothing in his announcements, however, that point towards US companies becoming any less competitive or delivering lower returns. We suspect that investors will continue to pay up for superior long-term returns from US companies.

Much of what defines the orthodox in terms of modern economic and monetary policy began with Thatcher and Reagan era. Indeed, the term Reaganomics has come to mean small state, low taxes and low inflation. More than that, however, it was also about a fundamental restructuring of the economy and the rise of supply side economics (the idea that growth is best stimulated through ‘trickle-down’ policies), specifically, promoting labour supply (the total hours a worker is willing to work at a set wage). To get all that going, however, required a significant hike in interest rates to squeeze out inflation (Figure 1) and a recession (or two) in the early 1980’s.

That said, it was the growth and prosperity that followed which defined Reaganomics, and the reliance on monetary policy. Think, about the major policy moves over the past few crisis — they have mostly come from central bankers. Governments have largely sat on their hands, leaving the economic leadership, stabilisation, and policy agenda to their unelected central bankers.

Figure 1: US Inflation and interest rates

This hands-off approach to economic policy from governments, allowed for a creeping and persistent economic inequality. As tax rates came down, the income share of the top 1% in the US rose from just over 10% to nearly 20% (Figure 2). Think about that, the top 1% of the US earn almost one fifth of the pre-tax national income — an astonishing amount. As interest rates fell, financial asset prices received a boost. That took the wealth share of the top 1% from 25% at the start of the period to 35% (Figure 3). Whichever way we look at it, the prosperity and growth that came with Reaganomics was not shared equally. It was the wealthiest that got wealthier. This free market small government approach was left wanting last year, with inequality tensions pushing to the surface. If that were not enough, it seems likely that COVID further amplified these inequalities. It was the poorest that got sickest and they were also least well supported as they lost their jobs.

When the US President announced his $1.8tn American Families Plan in April, to extend the economic safety net within the US, markets hardly reacted. Bearing in mind that this follows hot on the heels of the $2.3tn American Jobs Plan, and the $1.9tn American Rescue Plan, it is no small ask of Congress. Either markets doubt it will all get approved by Congress, or they are reconciled to a significant spending boost and the growth dividends that will surely follow. The proposed tax initiatives announced also point in the direction of reducing inequality. Maybe markets are reconciled to more interventionalist policies too?

Figure 2: US Tax rate v Income share of the top 1%
Figure 3: US Interest rate v Wealth share of the top 1%

If the US were to become more European regarding social equity, it does not mean slower corporate earnings growth. Figure 4 charts earnings growth for US and European listed companies — they are pretty much the same. That said, US companies tend to trade on a higher, more expensive, Price to Earnings (P/E) multiple that their European counterparts (Figure 5). Part of the reason for that is because the US stock market is dominated by technology stocks, but part is also down to superior returns, and specifically, a structurally higher Return on Equity (RoE) shown in Figure 6.

RoE is the portion of earnings that is attributed to part of the company owned by the shareholders (shareholder equity). These higher returns (and higher earnings multiples) have been sustainably achieved through a more efficient use of equity capital. American companies have a history of demonstrating more efficient capital allocation, and a greater degree of innovation than their European counterparts. These are cultural differences that will likely transcend alterations to the tax code, greater government spending or indeed a modernisation of US infrastructure.

Figure 4: US and European forecast earnings growth (12m forward)
Figure 5: US and European Price / Earnings Ratio (P/E)

We suspect that Biden’s fiscal changes will appear more radical to Americans than to Europeans. As for investors, well they are likely to continue paying up for superior long term returns from US companies. Figure 7 makes that clear, structurally hither US RoE coincides with outperformance in clients’ portfolios.

In the mid 1970s, the highest rate of income tax in the US was about 70%, having just fallen from 90%. Interest rates were a little over 5% but were set to triple before the end of the decade. Back then, flares were not just a fashion problem, and to describe the 1970’s as an economic problem would be an understatement. The policy and political solutions involved smaller government and low inflation aims and were delivered by Thatcher and Reagan. Together, they defined a new economic orthodoxy that endured for forty years.

Now, after COVID and with the US budget deficit topping $4tn and set to rise further, we have likely entered a new and equally radical economic regime. Like the last one, this is probably best described as a giant economic experiment, but there is nothing so far that we can see to stop US companies commanding a valuation premium over their European peers.

Figure 6: US and European Return on Equity (RoE)
Figure 7: US v Europe, relative Return on Equity and relative total returns %

Francis Menassa is the CEO and Founder of JAR Capital, an independent wealth and asset management firm headquartered in London.

Francis Menassa is the CEO and Founder of JAR Capital, an independent wealth and asset management firm based in St. James’s.